When it comes to implementing an investment portfolio, there are two crucial strategies that investors can use. These are asset allocation and diversification. Both of these strategies correlate the risks taken by investors in their portfolio for their given risk tolerance. Similarly, investors can limit their exposure due to risk due to concentrating all their investments in one asset using these strategies. Investors need to differentiate between these strategies to understand them better.
What is Asset Allocation?
Asset allocation helps investors balance their risks and reward by apportioning a portfolio’s assets according to various factors. In other words, asset allocation refers to the strategy in which investors divide their investment portfolio between several diverse asset classes to minimize the risks associated with their investment. There are three primary asset classes from which investors can choose, equities, fixed-income, and cash and equivalents.
When considering an asset allocation strategy, investors must consider various factors, as stated. Firstly, investors must consider their goals, which will dictate the risks and rewards they expect. Similarly, they must also regard their risk tolerance level. Lastly, investors also need to consider the time horizon of their investments.
Most experts suggest that investors must reduce their level of volatility of portfolios. Therefore, investors need to diversify their investment into various asset classes. Since every asset class has its own associated risks and rewards, the investors will achieve a diversified portfolio. Similarly, by investing in several asset classes, they can guard against any unforeseen circumstances in a better way.
The idea behind asset allocation is that when investors include various asset classes in their portfolio, a downturn in one asset class will not affect them in the same manner as if they had invested in a single class. By using asset allocation, investors can get compensated for the downfall of one asset class with an upturn in another one.
What is Diversification?
Portfolio diversification isn’t a new topic in the world of investing. It refers to the process in which investors include a wide variety of investments within their portfolio. The goal of diversification is to minimize the unsystematic risk of an investment. Therefore, the negative performance of one investment cannot affect the investors’ whole portfolio.
Diversification is different from asset allocation. With asset allocation, investors include investments from different asset classes in their portfolio. On the other hand, diversification applies to a single asset class. Therefore, if an investor buys only stocks of various companies or industries, they employ the diversification strategy, not asset allocation.
However, by diversification, investors cannot guarantee against a loss. Diversification helps in reaching a long-term financial goal while also minimizing risks. The idea behind diversification is that by having various stocks from several sources, investors don’t have to suffer due to an unforeseen event that can affect a specific investment or industry. However, that doesn’t mean they can protect their portfolio against events that affect the market as a whole. For that, they must use asset allocation.
Asset allocation and diversification are two strategies that investors use to manage their portfolios. While both are a crucial part of investing, there are some differences between both. Given above is a detailed analysis of what they are and how investors can use them in their portfolio management.